Thursday, April 8, 2010

Whenever someone tells me they are holding bonds as part of their fixed income allocation in a non registered account I sit them down and explain to them why they should have told me sooner.
In short, bonds are evil. they generate interest income. Interest income that is taxed at a prohibitive46.41% rate, unlike dividends. when the tax man is done with you, you only get to keep $53.59 out of $100.00 unlike eligible dividends where you get to keep $73.43 from $100.00 hence the 1.37022 money factor used to compare dividend income with interest income.

Dividends received by Canadian residents from Canadian corporations are taxed at a lower rate than interest income due to the dividend tax credit, which recognizes that a dividend is paid from the after-tax earnings of the corporation. Using the most recent proposed 2010 Ontario tax rates, an investor in the highest income tax bracket pays 46.41% tax on interest income and 26.57% on dividend income. Hence, the lower tax rate applied to dividends provides a significant advantage. After tax, an investor would retain $73.43 from $100.00 in dividends, but only $53.59 from interest income. Therefore, an investor would need approximately $1.37 ($73.43/$53.59) of interest income to equal $1.00 of dividend income before taxes are paid. This difference in the amount of income required before taxes is described as a “pre-tax interest equivalent” amount. This can be calculated by multiplying the amount of dividend income by a factor (1.37022 in the case of Ontario) that takes into account the different tax rates for dividends and interest.

No one under any circumstances should own bonds in a non tax advantaged portfolio. It is ludicrous to do so.

It is even more ludicrous if you have a non tax deductible mortgage on your primary residence. go sell your bonds immediately, and pay off the mortgage. a mortgage in essence is a short bond position. if you own both bonds and a mortgage. you essentially have a bond spread position, and the spread is not in your favor.

The correct way to invest in fixed income securites in an non tax advantaged portfolio is to invest in preferred shares. ( a topic for a future post ). These provide you with eligible dividend income, and much of the security of pricipal that comes with bonds.

About Me

Sharing my unique, contrarian and often controversial views on personal finance.
I am retired at 31, A software engineer who has had a short career and fulfilling carrer in online advertising.
Now turned into part time landlord and stock investor.
Achieved FIRE are 31, then was bored and lured back in by past co workers. Then FIRE again at a higher level at 35.
I achieved this working as a software engineer in online advertising, Investing most of it in rental properties in Toronto.